PART II: PENSIONS

BACKGROUND - STATE SECOND PENSION AND OCCUPATIONAL AND PERSONAL PENSIONS

The current position

SERPS and contracting-out arrangements

328. The UK pension system combines a contributory state scheme, consisting of basic Retirement Pension* and Additional Pension, derived from the State Earnings-Related Pension Scheme (SERPS), with a private system of occupational and personal pensions*.

329. All employees and self-employed people, except the very lowest paid, pay National Insurance contributions* (NICs). These give entitlement to the basic state pension. In addition, employees - but not the self-employed - earn entitlement to an additional, second-tier pension (SERPS), unless they choose to "contract-out" of SERPS and join a pension scheme which gives them rights in place of their SERPS entitlement.

330. For those who are, or have been, members of SERPS, the amount of Additional Pension they will receive is based on the amount of their "surplus earnings" in the years since 1978 when SERPS was introduced. Surplus earnings are those between the Lower Earnings Limit* (LEL) and Upper Earnings Limit* (UEL). The surplus earnings are increased in line with average earnings to the year before a person reaches state pension age in order to maintain their value in earnings terms. The total amount is multiplied by an accrual rate of between 25% and 20% depending on the year in which the person reaches state pension age (for anyone reaching state pension age from 6th April 2009 onwards, the accrual rate is 20%). This amount is then divided by the number of years in the person's working life since 1978 (up to a maximum of 49 for those who reach state pension age from 2027) to give the annual amount of that person's Additional Pension derived from SERPS.

331. SERPS is an earnings-related scheme, with higher benefits accruing to those who have had higher earnings throughout their working life. Lower earners accrue lower benefits and it is possibleto have worked and paid NICs throughout a working life and still receive a combined basic and Additional Pension which is less than is available through means-tested benefits. Those who have had breaks in their employment history for periods of caring or disability can be similarly affected.

332. Employers may choose whether or not to provide an occupational pension scheme and whether to contract-out of SERPS. For those who are contracted-out of SERPS, a National Insurance (NI) rebate is given in recognition of the fact that there is a reduced liability on the state.

333. A person contracted-out of SERPS may be a member of:

a "salary-related" occupational pension scheme, where the pension received depends on the employee's salary and service history. In such schemes employers and employees pay lower rate NICs;

a "money purchase" based occupational pension scheme. The contributions and any NI rebate are invested and, on retirement, can be used to buy an annuity. The final pension received depends on the investment performance of the scheme and the annuity rates available at retirement. Employers and employees pay a reduced rate of NICs and an age-related payment, which is increased with the age of the member, is paid to the pension scheme by the Inland Revenue; or

an "appropriate personal pension" (i.e. a contracted-out personal pension). In this case, employers and employees pay the full rate of NICs and an age-related payment is paid into their pension fund at the end of the tax year*.

334. Some occupational schemes are hybrid or "mixed benefit", combining features of salary-related and money purchase schemes. All personal pensions are provided on a money purchase basis.

335. Occupational pension schemes which are contracted-out must satisfy conditions which are designed to ensure that employees in these schemes, who are benefiting from NI rebates, receive pensions from the scheme which at least equal what they would have received from SERPS.

336. Prior to April 1997, in order for a salary-related scheme to contract-out, it had to promise to provide a Guaranteed Minimum Pension (GMP), which is broadly equivalent to what the SERPS entitlement would have been had the individual not contracted-out.

337. From April 1997, contracted-out salary-related schemes have had to satisfy a scheme-based test (reference scheme test). This requires schemes to meet a statutory standard laid down in the Pension Schemes Act 1993. The scheme actuary will certify that the test is met if the scheme provides benefits broadly equivalent to, or better than, those of the reference scheme.

338. Employees who join occupational pension schemes which have not contracted-out of SERPS, or non-appropriate personal pension schemes, accrue SERPS benefits as well as benefits under the scheme, but they do not receive NI rebates.

Occupational and personal pensions regulatory framework

339. There is a framework designed to protect the interests of scheme members within which occupational and personal pensions have to operate. This includes provisions to ensure that those who leave schemes before retirement can transfer or preserve their accrued rights, that pensions in payment receive some protection against price increases, that schemes are properly run and assets safeguarded, and that the benefits scheme members expect to receive are secure.

340. The Occupational Pensions Regulatory Authority (Opra) was established by the Pensions Act 1995* to regulate key aspects of the occupational pensions framework. The sale of personal pensions is regulated by the Financial Services Authority* (FSA).

Recent developments

341. The Government's proposals for the reform of the pensions system in Britain were set out in the Green Paper A new contract for welfare: PARTNERSHIP IN PENSIONS (Cm 4179), published in December 1998.

342. Key principles set out in the Green Paper were that the new pensions system should:

improve pensions for low earners and carers by reforming SERPS with a more generous State Second Pension;

introduce new stakeholder pensions for moderate and higher earners; and

continue to support and strengthen the framework for occupational pension provision.

343. Some of the measures to achieve the above aims were introduced in the Welfare Reform and Pensions Act 1999*. These include the legislative framework for the introduction of stakeholder pensions. It is intended to implement stakeholder pensions from April 2001. These schemes will offer money purchase benefits to members, providing benefits related to the contributions paid by the members, together with the investment returns on those contributions (less charges). The charges will be subject to an upper limit.

344. Stakeholder pension schemes will be targeted at those with moderate earnings (around £10,000 to £20,000 a year) who want to save more for retirement but who do not have access to an occupational scheme and for whom many existing personal pensions can be unsuitable or expensive. They will be set up within an approved governance structure (the arrangements for the management and oversight of a pension scheme) and meet minimum standards intended to encourage more moderate earners to save for their retirement. However, everyone will be able to pay into such a pension scheme, regardless of whether they are in work or not.

345. The Welfare Reform and Pensions Act 1999 also included legislation on several detailed proposals on occupational and personal pension schemes which were contained in the consultation document Strengthening the Pensions Framework that accompanied the 1998 Green Paper.

The measures in the Bill

State Second Pension

346. The State Second Pension will reform SERPS by boosting the Additional (second tier) Pension of low earners and providing Additional Pension for the first time for carers and some long-term disabled people with broken work records.

347. State Second Pension will be calculated by reference to the surplus in an individual's earnings factor. An individual's earnings factor corresponds to the whole of his earnings up to the Upper Earnings Limit and the surplus to the amount of those earnings between the Lower Earnings Limit and the Upper Earnings Limit.

348. The State Second Pension regime will provide for a new Low Earnings Threshold, which will be uprated in line with increases in national average earnings. In 1999-00 terms this Low Earnings Threshold will be £9,500. Anyone earning less than £9,500 but at or above the annual Lower Earnings Limit (£3,432 in 1999-00) will be treated for State Second Pension purposes as if they had an earnings factor of £9,500.

349. Carers, who have no earnings or earnings below the annual LEL, will be treated for State Second Pension purposes as if they had earnings of £9,500 for any year throughout which:

they receive Child Benefit* for a child under 6;

they are entitled to Invalid Care Allowance*; or

they are given Home Responsibilities Protection* because they are caring for a sick or disabled person.

350. Those entitled to long-term Incapacity Benefit* or Severe Disablement Allowance* throughout a tax year will also be treated for State Second Pension purposes as if they had an earnings factor of £9,500 in that year, provided they meet a simple labour market attachment condition when they reach state pension age. This condition requires that they have worked and paid Class 1 National Insurance contributions for at least one tenth of their working life since 1978, when Additional Pension was introduced.

351. There will be two stages to the State Second Pension. The first will be earnings-related for those earning above the Low Earnings Threshold. On the surplus in an earnings factor (actual or treated) of £9,500 (that is £9,500 less the prevailing annual Lower Earnings Limit), everyone will earn at least twice as much entitlement to Additional Pension as they did under SERPS. Where there is a surplus in the earnings factor corresponding to the amount of a person's earnings above £9,500 but not exceeding £21,600, the accrual rate on that surplus will be half what it would have been under SERPS. This will have the effect of recouping some of the increased accrual that everyone will receive on the surplus in the earnings factor of £9,500. However, everyone earning under £21,600 will receive more than they would have done under SERPS, with the largest proportionate gains going to those with the lowest earnings. Those earning £21,600 and above will receive the same as under SERPS.

352. In the second stage, to be introduced when stakeholder pension schemes have become established, State Second Pension will become a flat-rate scheme for those with a significant part of their working life ahead of them (for example, those aged under 45 at the point of change). In the second stage of State Second Pension, everyone who is contracted-in to the state scheme will be treated as if they had earnings of £9,500 (or corresponding to the prevailing Low Earnings Threshold at that time), regardless of the level of their actual earnings. Qualifying carers and long-term disabled people with broken work records will continue to be treated as if they had such an earnings factor. State Second Pension will continue to be calculated by reference to the surplus in that earnings factor. National Insurance rebates to those in contracted-out pension schemes will remain earnings-related.

Contracting-out arrangements

353. The Government views the contracting-out regime is central to the success of private pension provision and is keen to ensure that any changes made to the arrangements for contracting-out reflect the introduction of the State Second Pension, supporting and encouraging private pension provision.

354. When individuals contract-out they do so on the basis that their pension arrangements will give them, broadly speaking, what they would have received from the state had they not contracted-out. As there is a reduced liability on the state, individuals and employers running occupational schemes receive a contracted-out rebate, which is calculated by reference to the value of the state benefit given up. The Government Actuary conducts a review every 5 years to determine the appropriate level of the rebate. The next review, due to take place later this year, will consider the level of rebates with effect from 2002.

355. As the State Second Pension is designed to boost the pension of low and moderate earners, the Government intends to change the contracting-out arrangements to ensure that members of contracted-out pension schemes are not better off contracting back in. Proposals on how the future contracting-out regime could be structured were the subject of a consultation exercise which ended on 14th January 2000. After giving careful consideration to all the responses, the Government has decided to introduce measures which provide for:

all rebates for contracting-out into a personal pension, including a personal pension based stakeholder pension, to be calculated to reflect the enhanced 3 part accrual rate in the State Second Pension;

rebates to continue to be calculated as they are now for all occupational pension schemes, which will not be required to change their benefits;

people in all contracted-out pension arrangements on low earnings (up to £9,500) to get a top-up from the State Second Pension; and

the top-up to be extended to people on moderate earnings (up to £21,600) in contracted-out occupational pension schemes.

356. The combination of these measures will ensure that low and moderate earners in contracted-out provision will also benefit from the extra help that the State Second Pension will give. This will simplify the choice of alternative pension vehicles available to them, without their having to contract back in to the state scheme to access that help.

357. These proposals will also apply when State Second Pension becomes a flat-rate scheme for those who are contracted-in to the State scheme. Rebates and any state scheme top-up will continue to be earnings-related. This will prevent disruption to schemes at that stage, as well as providing an incentive for moderate earners to contract-out of the state scheme into a funded arrangement and ensuring that they will continue to be better off under State Second Pension.

Contracted-out Personal Pension Schemes

358. The rebate for contracted-out personal pension schemes will be based on the different accruals within the State Second Pension. For example, as the accrual rate for those earning at or above the annual LEL but below £9,500 will double in relation to SERPS, so will the rebate. Low earners will therefore get a rebate based on a 40% rather than a 20% accrual which will be paid directly into their pension fund. For moderate earners it will be based on 40% on the first band of earnings, up to £9,500, and 10% on the second band, up to £21,600.

359. However, unlike State Second Pension, which will treat those earning at or above the annual Lower Earnings Limit but below £9,500 as if they were earning that amount, the rebate for low earners will remain based on actual earnings. To ensure that they still get the extra help from the low earner's boost, they will get a State Second Pension "top-up". In broad terms, the top-up will operate by calculating the State Second Pension an individual would have received had he not contracted-out (which of course includes the low earner's boost) and taking away an amount which represents the pension derived from the rebate.

360. This means that someone earning £8,000 would receive benefits from their pension scheme based on their actual earnings of £8,000 and a State scheme top-up based on £1,500 (the difference between actual earnings and £9,500). The rebate would be based on 40% of actual earnings between the Lower Earnings Limit and £8,000, and the top-up would be based on applying the 40% accrual to the £1,500.

Contracted-out Occupational Schemes

361. The system will operate slightly differently for occupational schemes in order to cater for the Pensions Industry's desire to avoid disruption to employers. Occupational schemes will therefore continue to have their reduced rate of National Insurance contributions calculated on the same basis as now - that is, a uniform accrual rate of 20%.

362. In order to ensure that individuals in these schemes receive the extra help intended for low and moderate earners, an extended State Second Pension "top-up" will apply. It will work on the basis of calculating the State Second Pension that an individual would have received if he had not contracted-out, less a deduction equating to a pension derived from the rebate input (ie 20% of actual earnings).

363. This means that for people in occupational schemes, all the extra help is delivered by way of the State scheme, rather then partly through their scheme via the rebate, and partly through the state, as is proposed for personal pension schemes.

Protection of "inherited SERPS"

364. As a result of changes originally enacted in the 1986 Social Security Act, the amount of additional pension a surviving spouse could expect to inherit was due to be halved in respect of a married person who died after 5th April this year. The Welfare Reform and Pensions Act 1999 included provision to make regulations that would provide for, among other things, the deferral of the start of the new rule to a later year, and the setting up of a scheme to determine who may suffer future financial loss as the result of incorrect information about the impending change.

365. This Bill provides for the new rules to apply from October 2002 (but also provides that this date may be further postponed by regulations) and clarifies the eligibility criteria for the Inherited SERPS scheme.

Improving pensions information

366. The Bill also contains a measure to improve overall pension information for individuals so that they have a clear indication of what sort of retirement income to expect and can therefore make better-informed decisions on what savings they need to make. This will:

permit state pension information to be passed to employers and pension providers so that they can issue pension statements giving details of both state and private pension rights unless individuals have indicated that they do not want the information. Because employers and pension providers will not need to gain the express consent of individuals the measure will improve the take-up of combined pension statements by employees and reduce administrative burdens; and

provide that state pension details can be passed to other third parties such as organisations which provide financial information services so that individuals who give consent can access their state pension details through these services.

Improving the framework for occupational and personal pensions

367. Besides the reform of the National Insurance rebate, there are four main parts to the reform of occupational pensions in the Bill:

increased member involvement in schemes by requiring that all schemes must have one-third Member-Nominated Trustees (MNTs) by a process laid out in regulations or under procedures devised by the employer and approved by scheme members. The purpose is to increase confidence in the schemes, thereby encouraging more employees to join;

further protection of members' pension rights by:

allowing the Occupational Pensions Regulatory Authority* (Opra) to make their register of disqualified trustees more accessible to the public; and

giving powers to Opra to monitor schemes which are in the process of winding up to ensure that winding up is undertaken as quickly as possible;

changes to the existing regulation-making powers to enable future regulations to require money purchase schemes to provide members with an illustration of the likely future value of their pension, thereby improving members' appreciation of the value of their pension rights; and

measures toprovide further clarification, simplification and flexibility for those operating schemes. These will:

increase the options for discharging contracted-out pension rights;

increase the options available to scheme members when they transfer their pension rights; and

allow a greater range of persons to make representations to the Pensions Ombudsman.

COMMENTARY ON CLAUSES

CHAPTER I: STATE PENSIONS

State second pension

Clause 30: Earnings from which pension is derived

368. Subsection (1) inserts a new subsection (2A) into section 22 of the Social Security Contributions and Benefits Act 1992* (the "Contributions and Benefits Act") which sets out the earnings on which Additional Pension (in the State Earnings-Related Pension Scheme or SERPS) is calculated. Under State Second Pension, Additional Pension is to be calculated on those earnings on which Class 1 employee National Insurance contributions have been paid or treated as paid.

369. From April 2000 employees earning below a new Primary Threshold will no longer pay National Insurance contributions. Those employees with earnings between the prevailing Lower Earnings Limit (LEL) (£66 a week in 1999-00) and the new Primary Threshold* will be treated as if they had paid National Insurance contributions on those earnings. Provided their annual earnings are at least 52 times the weekly LEL (£3,432 in 1999-00), the year will qualify for contributory benefits such as basic Retirement Pension. If their earnings exceed this amount, employees will accrue entitlement to Additional Pension on the amount by which their earnings exceed 52 times the LEL.

370. The self-employed do not accrue entitlement to Additional Pension. Their flat-rate Class 2 National Insurance contributions entitle them to flat-rate contributory benefits, such as basic Retirement Pension. However, someone may be both an employed earner and a self-employed earner in the course of a year. In such a case, if they are a member of SERPS as an employed earner, their Class 2 contributions are currently taken into account when calculating the amount of surplus Class 1 contributions on which their entitlement to Additional Pension is based. But if they are contracted-out of SERPS into an occupational pension or personal pension scheme, they receive a rebate of National Insurance contributions which is based solely on their Class 1 employee contributions. This section has the effect of treating members of State Second Pension in a similar way as those contracted-out. Only Class 1 earnings will be taken into account when calculating the amount of their State Second Pension entitlement.

Subsection (2)(a) inserts new paragraph (za) into section 44(6) which sets out how earnings factors are to be determined for State Second Pension purposes. For State Second Pension the earnings factor will be the total of the earnings on which Class 1 employee National Insurance contributions have been paid or treated as paid, unless the person concerned is treated as having an earnings factor for one of the reasons set out in section 44A of the Contributions and Benefits Act (inserted by subsection (3), see below).

Subsection 2(b) amends section 44(6)(a) to limit the current method of determining earnings factors for Additional Pension under SERPS to the period before "the first appointed year", which is the year from which State Second Pension will take effect.

371. Subsection (3) inserts new section 44A into the Contributions and Benefits Act.

New section 44A: Deemed earnings factors

372. New section 44A(1) provides for a person to be deemed to have an earnings factor equal to the Low Earnings Threshold when calculating entitlement to Additional Pension under the State Second Pension if they qualify in any of the ways set out in newsection 44A(2). In 1999-00 terms the Low Earnings Threshold will be £9,500 (see new section 44A(5) below).

New section 44A(2)(a) provides for a person to be treated as if they had an earnings factor of £9,500 in a qualifying year when they had earnings at or above the level needed to make the year a qualifying one for basic pension (earnings at or above the annual LEL of £3,432 in 1999-00, which is 52 times the weekly LEL of £66 a week in 1999-00) but less than the Low Earnings Threshold (£9,500).

New section 44A(2)(b) provides for a person to be treated as if they had an earnings factor of £9,500 in a qualifying year if Invalid Care Allowance was paid to them throughout the year. A person can also qualify if they would have been entitled to receive Invalid Care Allowance were it not for the fact that they received another (higher) benefit, such as widows' benefits* or Incapacity Benefit.

New section 44A(2)(c) provides for a person with no earnings, or earnings below the LEL, to be treated as if they had an earnings factor of £9,500 in a qualifying year when they were paid Child Benefit for a child under 6, or if they satisfied certain other conditions to be specified in regulations. It is intended that these other conditions will be the same as those specified in regulations 3 and 4 of the Social Security Pensions (Home Responsibilities) Regulations 1994 (S.I. 1994/704). These regulations provide for a person to be treated as being precluded from regular employment by responsibilities at home if:

(i) they receive Income Support*, because they are caring for a sick or disabled person (and therefore are not required to be available for work); or

(ii) they spend at least 35 hours a week caring for a person who receives Attendance Allowance* or the care component in Disability Living Allowance* at the middle or highest rate.

New section 44A(2)(d) provides for a person to be treated as if they had an earnings factor of £9,500 in a qualifying year if long-term Incapacity Benefit was paid to them throughout the tax year. A person can also qualify if they would have been entitled to receive long-term Incapacity Benefit but failed to satisfy the necessary contribution conditions for that benefit, or received another (higher) benefit, such as widows' benefits*, or received an occupational or personal pension which reduced the amount of Incapacity Benefit to nil. Such a person would also need to satisfy the labour market attachment test set out in new section 44A(3)and (4) below.

373. New section 44A(3) and (4) detail the labour market attachment conditions for those who could qualify for State Second Pension on grounds of entitlement to long-term Incapacity Benefit. Such a person must have paid, or be treated as having paid, Class 1 employee National Insurance contributions for at least one tenth of their working life since 1978, when Additional Pension was introduced. (A full working life for state pension purposes is counted from the start of the tax year in which a person reaches 16 to the end of the tax year before the one in which they reach state pension age). For instance, someone reaching state pension age in 2005-06 would have a working life of 27 years and would need to have worked and to have paid National Insurance contributions for 3 years (1/10th of 27 years rounded to the nearest whole year) in order to receive entitlement to State Second Pension on grounds of incapacity for work. Anyone reaching state pension age after April 2024 would need 5 years (working life of 46 years, up to a maximum working life of 49 years, 1/10th rounded to the nearest whole year being 5 years). National Insurance credits* will not satisfy this condition. However, any year in which the person has worked but not actually paid Class 1 National Insurance contributions because their earnings, although above the annual LEL, were below the new Primary Threshold on which such contributions are paid, will be treated as if they had paid contributions on those earnings.

374. Any year when the disabled person has been a carer and qualifies for State Second Pension by virtue of subsections (2)(b) or (c) above will be excluded from the number of years in the working life when calculating whether they have met the labour market attachment condition. For instance, someone retiring on 6 April 2024 would have a working life of 46 years and would need 5 years (1/10th of 46 years rounded to nearest whole number) in which they had worked and paid Class 1 National Insurance contributions. But if they had received Child Benefit for a child under 6, and were treated as precluded from regular employment by responsibilities at home for those 5 years whilst the child was under that age, or if they were entitled to Invalid Care Allowance for 5 years, their working life would be reduced to 41 years and they will only need 4 years (1/10th of 41 years rounded to nearest whole number).

375. New section44A(5) sets the Low Earnings Threshold in State Second Pension at £9,500. This is subject to new section 148A of the Social Security Administration Act 1992* (the "Administration Act") which provides for the Low Earnings Threshold to be increased in line with rises in national average earnings (see the note to subsection (1) of clause 33 below).

376. New section 44A(6) defines "occupational pension scheme" and "personal pension scheme" as used in the inserted new section 44A(2)(d)(ii).

377. Subsection (4) of clause 30 provides for someone to be treated as if they had an earnings factor of £9,500 in a qualifying year if they are paid Severe Disablement Allowance (SDA) throughout the year and they meet the labour market attachment test set out in new section 44A(3) and (4). SDA is being withdrawn for new claimants from April 2001 but those already receiving the benefit will continue to do so.